The Dow Jones Industrial Average dropped 353.87 points, or 2.34%, to 14758.32, on big volume, marking its first back-to-back decline of 200 points or more since Nov. 1, 2011. Yields on Treasurys hit their highest since August 2011 as bond prices fell.

The turmoil exposed vulnerabilities in the financial markets and the world economy that had been mostly ignored because central banks were willing to ride to the rescue with huge amounts of money.

Investors said Thursday they were buffeted by two distinct forces: worries about the health of China's economy and financial sector, and the prospect that the beginning of the end of the Fed's extraordinary stimulus could reverse the huge rally in assets ranging from "junk" bonds to dividend-paying stocks. Gains in many of those assets had been fueled by ultralow interest rates and expectations that the Fed would continue to pump money into financial markets.

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The rout underscored persistent worry about the health of the global economy at a time when the U.S. and Europe are struggling with high unemployment. Adding to the wrenching action is a report that financing for cash-strapped Greece could be in danger, and a cash squeeze in China, which is trying to tighten the spigot on credit without causing problems.

Early Friday, rates in China's money markets fell sharply on rumors that Beijing had ordered its big banks to loosen up cash. Still, they remain more than double than average for the year, and the turbulence suggests continued uncertainty in the market for cash in coming days.

The declines came a day after Fed Chairman Ben Bernanke said that the central bank expects to begin to pare its huge bond-buying program later this year and that it could end sometime next year, provided the economy unfolds as the Fed expects. The prospect of the Fed weaning the economy off unusually easy credit at a time when the pace of U.S. economic growth is modest and inflation is below the Fed's target jolted markets around the world.

At the same time, many investors believe the shakeout heralds a shift toward higher interest rates and sustained, healthier U.S. growth, following a long period of superlow rates that helped feed investor funds into higher-yielding investments. Those investments have declined sharply in recent weeks as the market has begun preparing for more-normal rates.

The action showed investors continue to grapple with the impact of an eventual reduction of the Fed's $85 billion in monthly bond purchases. U.S. bonds and stocks have broadly risen this year, with few sizable declines until the past month.

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The market reactions were a potential jolt to the Fed. Central-bank officials have been speaking publicly for weeks about the possibility of winding down the bond-buying program. Mr. Bernanke sought to emphasize in remarks Wednesday that the Fed would stand down from reducing stimulus if the economy stumbles.

Markets were jarred by the potential timetable the Fed chairman laid out. "With the Fed beginning to discount an exit from their policy, you're not only potentially decreasing asset prices—you're also increasing volatility," said Eric Stein, a portfolio manager on the $6.8 billion Eaton VanceEV-0.93% Global Macro Absolute Return Fund.

Some investors say the economy remains on track for solid expansion. The Philadelphia Fed manufacturing index rose Thursday. "I find it difficult to think this is the onset of a bear market when the economy is getting stronger, but reverse psychology is getting a strong grip today," said Andrew Wilkinson, chief economic strategist at Miller Tabak & Co.

Cracks in the global growth story have widened. In Europe, yields on sovereign debt have started to rise again after a substantial decline, while unemployment remains high and growth prospects are mixed.

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In China, a key measure of interbank funding stress briefly touched 25%, reflecting overextended loan books and deteriorating asset quality, which are forcing banks to tap the money market with increasing urgency to fund their daily operations. The spike raises new questions among economists and investors about the country's near-term prospects.

"Maybe we went from too complacent to almost too concerned…but clearly there are problems in many pockets of the globe," said Mr. Stein.

Major stock markets in Europe fell Thursday, and Asian markets declined in early trading Friday.

In the U.S., some of the hardest-hit sectors were those that did best during the Fed-fueled run to stock-market records this year. Utilities and consumer staples declined, and the Russell 2000 Index, a small-cap index that held up well after the Fed news Wednesday, was the worst performer among the major indexes, losing 2.6%.

"Every fast-money [investor] wants out," said Matthew Cheslock, trader with brokerage firm Virtu Financial, meaning much of the selling came from firms such as hedge funds rather than longer-term investors.

On Thursday, exchange-traded funds accounted for 41% of dollar volume in U.S. equity trading, compared with a 24% average for 2013, according to Stifel, Nicolaus & Co. That was a sign of heavy trading by hedge funds.

Shares of home builders sank—reflecting fears that rising mortgage rates could damage the U.S. housing recovery, viewed as a key cog in any broader economic recovery.

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Municipal-bond prices suffered their steepest one-day fall since October 2008, according to Thomson Reuters Municipal Market Data. The yield on Fannie MaeFNMA-4.28%-guaranteed mortgage-backed securities rose 0.08 percentage point to a 20-month high of 3.29%, according to Credit SuisseCS0.03% data. The rising mortgage yields will likely pressure consumer home-loan rates, setting up a test of housing. The national average 30-year mortgage rate this week declined slightly to 4.12% from 4.14%, which was a 14-month high, according to Bankrate.com.

A report Thursday showed housing strength hasn't abated. Sales of previously owned homes rose in May to the highest level since late 2009, said the National Association of Realtors. But if mortgage rates climb to 4.5%, that would cut what borrowers could afford to spend on a home by 11.25%, according to Scott Buchta, head of fixed-income strategy at Brean Capital.

With the latest selloff, the 10-year Treasury note yielded 2.419%, up from 1.629% early last month. Despite the increase in rates and the mixed signals on the economy, some investors continue to see bonds as a questionable bet.

At these yield levels, "risk-free is now risky in terms of fixed income," said Richie Prager, global head of trading and liquidity strategies at $3.9 trillion asset manager BlackRock Inc.

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